Sole proprietorships and partnerships

Five attributes that separate business forms

In most market economies there are three broad kinds of organisation, each with its own purpose and legal rules: businesses (companies run for profit), not-for-profit organisations (non-profits) and governments. Analysts mostly study businesses, because businesses are the main users of the capital that investors provide. Non-profits and governments still matter here, mainly as owners of businesses.

When founders set up a business they choose a legal organisational form. That choice decides how returns, risks, ownership and operating responsibilities are shared. Three broad forms exist almost everywhere: the sole proprietorship (or sole trader), the partnership and the limited company.

Each country has its own names and variants, so do not memorise national rules. Instead, compare any form on the same five questions below. They are exactly what an analyst should ask about a new investment candidate.

• Legal identity: is the business a legal person separate from its owners?
• Owner-manager relationship: are the owners also the people who run it?
• Owner liability: can owners be made to pay the business's debts from personal assets?
• Taxation: are profits taxed at the business level, the owner level, or both?
• Access to financing: how easily can the business raise capital to grow and spread risk?

Sole proprietorship: simple, but one person carries everything

In a sole proprietorship a single owner puts up the capital, often personal savings or a personal loan, runs the business day to day and keeps every unit of profit. There is no legal separation: the business is simply an extension of the owner. In some places no registration is even needed, and the business ends when the owner stops trading or dies.

The owner takes all the return and all the risk. Profits are taxed as the owner's personal income, and the owner has unlimited liability: if the business cannot pay a supplier or a bank, the creditors can pursue the owner's house and savings.

Sole proprietorships are the most numerous businesses in most economies, because they are cheap and flexible. A family bakery or a freelance designer is the typical case. Their growth is capped by how much one person can invest, borrow and stand to lose.

Partnerships: pooling money, skills and risk

A general partnership has two or more owners, called general partners. It works like a sole proprietorship with more people: partners bring extra capital and complementary skills (sales, finance, operations, legal) and share control, profits and losses. A written partnership agreement usually sets out roles and profit shares, but a partnership can also arise verbally or simply through how people act together. Builders, small service firms and joint ventures between companies are common examples.

The catch is that all general partners have unlimited liability, shared among them. If one partner cannot pay his part of the debts, the others must cover it in full. Growth is still limited by what a few people can contribute and how much personal risk they will accept.

A limited partnership fixes part of that problem. It needs at least one general partner (GP), who has unlimited liability and usually runs the business. All other partners are limited partners (LPs): they can lose at most what they put in, their personal assets are protected, and they normally have no management role. Profits and losses are split as the agreement says, usually with a larger share for the GP in return for the extra risk. Agreements can be complex, with several tiers of partners, and they often restrict transferring a partnership interest or adding new partners.

Some jurisdictions also allow a limited liability partnership (LLP): a partnership with no general partner, where every partner has limited liability and the partners share management, usually by appointing managing partners. In some countries (the United States, for example) LLPs are restricted to professional firms such as law, accounting, engineering or architecture practices, with limits on the number of partners and on outside equity.

Pass-through taxation

Sole proprietorships and partnerships are usually pass-through businesses. The business itself pays no income tax; its profit or loss is passed to the owners, who pay tax at their personal rates according to their share.

A key detail: owners are taxed on their share of profit whether or not it is paid out. If a partnership keeps profit to reinvest, the partners still owe tax on it that year. This becomes an important contrast with corporations in a later lesson.

Limited liability is what lets passive money in. An outside investor will fund a business they do not run only if their downside is capped at what they invest.